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Goldman-Facebook Deal Raises Debate on Investor Pool

By Azam Ahmed January 5, 2011 10:47 amJanuary 5, 2011 10:47 am

7:46 p.m. | Updated

After news broke of the investment by Goldman Sachs in the social networking site Facebook, a harsh spotlight was cast on a nearly 50-year-old law that limits the number of shareholders in a private company.

In 1964, regulators started requiring companies with more than 499 shareholders to publicly report their financial results. It is a rule that has been debated from the outset — and the issues raised now are the same ones raised then.

To some, the structure of the Goldman deal merely looks like a way to circumvent the law. Through a special purpose vehicle, the firm could potentially pool money from thousands of wealthy clients and still be considered one investor because the entity would be managed by Goldman.

Section 12 (g) of the Securities Exchange Act of 1934 came about in the 1960s as over-the-counter trading in shares of privately held companies began to heat up and regulators worried that investors were not getting enough information.

George Tames/The New York TimesHugh F. Owens, a member of the S.E.C. in the 1960s, questioned the reliability of information about unlisted stocks in that era.

A special study from that period found that the “disclosures voluntarily made by unlisted companies left a great deal to be desired,” according to a speech by the S.E.C. commissioner at the time, Hugh F. Owens, given before the Practicing Law Institute in New York in 1964.

“Not only did the volume of information delivered to shareholders vary considerably, but the candor with which it was presented was highly variable,” he said in the speech.

“They involve thousands of corporations and hundreds of thousands of investors. The Securities Acts Amendments of 1964 effectively remove the distinction, which has existed as to a large number of the companies whose securities are traded over-the-counter.”

That is the same sort of issue facing regulators now, with shares in Facebook trading at a frenetic pace on the secondary market. The announcement that Goldman will use a special purpose vehicle to raise and invest $1.5 billion in the company — money collected from a variety of wealthy individuals — has only intensified the scrutiny.

In practice, a large fund that represents hundreds or thousands of individuals can be considered a single record holder.

“So long as Goldman is the sole decision maker for all investors it’s irrelevant,” said Eleazer Klein, a partner at the law firm Schulte Roth & Zabel.

Even so, questions remain about whether such a deal may stray from the spirit of the law while adhering to its letter.

“Whether something is done primarily to circumvent the rules is a philosophical question,” Mr. Klein said. “There is a natural tension between being allowed to structure something in a manner that complies with the law and at the same point circumvents the law.”

How did the government come up with the 500-shareholder limit, a threshold that over the years has been called both too high and too low?

The government did not want to subject small companies with limited shareholders to the costs of regulation and compliance. At the same time, regulators did not want to allow large companies with a multitude of investors to reap the benefits of public financing without disclosure and registration.

Ultimately, lawyers say the number was picked arbitrarily. Scientific or not, it all comes back to investor protection.

One issue today is whether wealthy investors — like those who will participate in the Goldman deal — need the same protection as smaller investors. There are plenty of examples where the government has determined that they do not, as with hedge funds and private equity investments.

“We’ve lowered the bar for certain types of investors that we felt need less protection,” said Christian Leuz, a finance professor at the University of Chicago Booth School of Business. “But maybe what we’ve learned in recent years after the financial crisis is that sophisticated doesn’t always mean high net worth.”

Although the 500-investor threshold has long been the subject of debate, start-ups like Google raised it to a new level in the last decade. Many private technology companies reward and attract talent by offering stock options or shares in the company.

Those employee-owned shares typically do not count toward the 500-investor limit. But once those shares are sold on a private exchange — often after employees leave the company — they are no longer exempt. Venture capital firms, too, divest shares in the secondary market.

The development of this changing dynamic has only complicated the numbers game.

“Prior to that, it was pretty easy to maintain less than 500 shareholders,” said Adam C. Pritchard, a professor at the University of Michigan Law School.